As this time of year calls for the self-indulgent to foist their prognostications upon the polite, I couldn’t help but take the opportunity to call on my friend Captain Obvious to do the same. While most market forecasts are promulgated by the learned, I knew that Captain Obvious’s ego would insist that his voice be heard, regardless of his expertise on such matters. Speaking on the fixed income markets, I can therefore report that Captain Obvious forecasts thusly:
Rates Will Rise
Look at a chart of G-10 market yields since the 1980s. Today’s levels look kinda low, don’t they? Yes, inflation is low, and interest rates are suppressed due to policy actions, but someday the worm will turn and rates will rise. Please note that Captain Obvious has been wrong about “when” on this topic for several years.
Spreads Will Widen and Be More Volatile
One result of negative rates is that investment is channeled into higher yielding, but often riskier, activities. Once rates start to rise (see the obvious forecast above), the riskier activities among the bunch will be denied financing and go into default, which in turn will lead to wider and more volatile spreads, as investors worry about who will be the next to default.
Regulation Will Persist
Despite avowals from all past presidents (George Washington excluded) to reduce government involvement and regulation, government hiring has steadily increased. Regulation can be a good thing. Captain Obvious is a fan of the SEC 40 act, for instance. However, other regulation, no matter how well intentioned, can cause serious side effects. The Volker Rule has had a deleterious impact on the liquidity in the bond market, which in turn should widen bond spreads when the next crisis hits (see obvious forecast above).
Policy Risk Will Drive Market Risk
As quantitative easing eventually dissipates, and regulation increases (see obvious forecasts above), the markets will react to these policy changes, instead of the normal fluctuations of the market reacting to itself. Policy risk is episodic, extremely hard to model in the existing market risk framework, and divination of its direction is best left to oracles, seers, and mystics. The deluge of expected policy changes will drive market reactions to those policies, which in turn will make traditional risk management activities difficult.
Despite claims of a happy childhood, the future according Captain Obvious is brutish, nasty, and short on the good days. However, the redeeming feature of all this turmoil, is that typically in times of uncertainty and transition, the hunt for alpha is more successful. Assuming you can stand it.
Bill has written and spoken extensively on fixed income hedging and return attribution. He has earned a Master degree in Operations Research from the University of North Carolina and is a Chartered Financial Analyst and Professional Risk Manager.